Valor: Brazil’s Central Bank is in search of lost credibility

One of the biggest Brazilian achievements in the last few years was facing a serious global crisis without having to raise interest rates. It was like that in 2008. The crisis arrived, forcing economic activity to stop suddenly in the last quarter of that year and the Central Bank (BC), after normalizing liquidity in the money and foreign-exchange markets, took the base interest rate, Selic, to the lowest level in history until then.

The standard until that crisis, since the launch of the Real Plan, in 1994, was another. Domestic or international turbulence usually generated a balance of payments crisis, followed by significant currency devaluation and rising inflation. The economy usually entered a recession. To restore investment confidence and face the inflation problem, the BC applied an interest-rate shock, even with the economy running out of steam.

The last time that the Monetary Policy Committee (Copom) raised interest rates to face the balance of payments problem (and restore lost confidence) was in 2003, the first year of the Luiz Inácio Lula da Silva administration. Monetary-tightening cycles from then on (in 2004/2005, 2008 and 2010/2011) were promoted to contain domestic demand and thus inflation.

Now, Brazil is not in a crisis, despite the fact that GDP has been showing subpar growth over the last two years and is on its way to perhaps the third year of such a situation. Despite that, everything indicates that the Copom is preparing to raise the Selic rate, repeating the standard reaction of a past that everybody thought had been left behind.

In 2003, when the BC appealed to an interest-rate shock to force some order, domestic absorption, or the sum of consumer and government spending, besides investment as a percentage of GDP, showed a negative variation. That year, GDP only rose 1.15%. Still, 12-month inflation topped 17%.

In the following monetary-tightening cycles, the interest rate was raised to contain the expansion of domestic absorption, which grew over 4% in 2004 while GDP expanded 5.71%; in 2008, it rose over 6% while GDP had 5.17% growth; and in 2010 it rose almost 9%, while GDP expanded 7.5%. Interest rates rose to control inflation.

The situation now is completely different. In the last quarter of 2012, domestic demand, already seasonally adjusted, rose 1.2% in comparison to the same quarter of the previous year. GDP, meanwhile, rose only 0.6% in the same period. It’s actually in such an environment, or perhaps in a less tragic one (this year’s second quarter), that the Copom will start a new cycle of rising interest rates.

The Brazilian economy seems to be locked in the low-growth and high-inflation trap. There’s a considerable chance that the 12-month Extended National Consumer Price Index (IPCA) up to March will top the ceiling of the inflation-targeting regime (6.5%). It’s becoming difficult to find anybody who believes in GDP growing above 3% in 2013. Faced with that, raising Selic sounds out of place.

Why then start a monetary-tightening cycle? Apparently because the BC needs to start again coordinating the expectations of economic agents, which have been without an anchor since the second half of 2010. If it doesn’t do that any time soon, it runs the risk of seeing inflation becoming increasingly resilient. A good hint of what’s going on can be glimpsed from market expectations for IPCA and Selic according to the BC’s weekly Focus Survey.

Data shows that in the latest survey, from March 1st, most analysts – slightly over 55% of the total – believe that 2013 will finish with 5.8% inflation, the same of last year. On December 31st, less than 40% of those surveyed were expecting that. Expectations thus deteriorated, while estimates are that the IPCA will remain at a level well above the 4.5% goal.

Regarding expectations for Selic 12 months from now, the complete opposite is seen – they have no anchor. Until December 31st, over 60% analysts surveyed by Focus believed Selic would be at 7.5% a year in December 2013, thus including an increase of 0.25% from its current level. Analysts are divided now: Around 30% continue to think that Selic will stay at that level, while slightly less than 30% believe the interest rate will be between 8.5% and 9% per year 12 months from now.

“The government’s biggest error was to discredit inflation expectations,” says Mário Torós, a former BC director that today is a partner at Ibiúna Investimentos and responsible for managing over R$2.5 billion in multimarket and stock funds. In fact, since the beginning of the current administration, the BC’s inflation-fighting strategy changed several times, hurting policy predictability. The monetary authority only managed to coordinate expectations, or, in other words, to convince agents that IPCA was on its way to something close to the 4.5% goal in July 2012.

“The current picture deserves a deeper interpretation. A scenario is becoming consolidated, under which the BC prepares the beginning of a cycle of rising interest rates with a GDP hiatus [the spread between potential and effective GDP] still open. The economy is clearly growing below potential GDP,” Mr. Torós says. “[Raising the interest rate] is a step backwards.”

It is evident that the perception of economic agents (and their expectations) wasn’t affected only by the BC’s action, but by a series of measures the government has been adopting at all costs to stimulate economic growth. The list is big and includes, among other initiatives, increasing import duties for over 100 products, such as steel, which has already seen price raises twice this year alone; the end of the contractionary fiscal policy; and the strong currency devaluation between 2011 and 2012 (a policy, we must note, partially reversed since December).